Insights and Opinions

Sunday, November 11, 2007

Tips On Starting A Venture

Below are ten tips for entrepreneurs who are launching a start-up that will seek venture capital (“VC”) financing.

1. Protect Yourself from Personal Liability. The entrepreneur’s first step in connection with launching a start-up should be to form an organization that will protect against personal liability. As discussed below, a Delaware C-corporation is the structure that VC investors will generally require; however, if a financing is not imminent, it may be prudent for the entrepreneur to form an S-corporation or a limited liability company to obtain “pass-through” tax treatment (and then convert the entity to a C-corporation down the road, if necessary) to take advantage of the company’s initial losses, if applicable. The bottom line is that the entrepreneur should seek the advice of counsel in connection with the formation of any business organization, including the advice of tax counsel (e.g., shareholders in S-corporations -- as opposed to C-corporations -- are not eligible for the “qualified small business stock” capital gains tax break; and losses in C-corporations may be deductible up to $50,000/yr. or $100,000/yr. on a joint return with respect to “Section 1244 stock”).

2. Form a Delaware C-Corporation. In the VC world, it is relatively common for funds to invest in Delaware (or perhaps California) C-corporations. From a tax perspective, VC funds generally have no desire (and may not be permitted under their respective fund documents) to invest in pass-through entities. From a corporate perspective, Delaware is the most common state of incorporation (regardless of where the operations are located) due to its well-developed case law, management protections and flexibility -- and from a practical standpoint, it is the easiest state with which to deal with respect to corporate filings, etc. Despite Delaware’s appeal, if the business has substantial operations and a majority of its shareholders located in California (a so-called “quasi-California corporation”), it may be simpler to form the corporation in California (i) due to the uncertainty regarding Section 2115 of the California Corporations Code, which purports to apply certain significant statutory provisions to quasi-California corporations (even if they are incorporated in Delaware); and (ii) the state-law requirement that a quasi-California corporation (or a corporation that otherwise has sufficient contacts with California) that is incorporated in Delaware or any other state must qualify to “do business” in California (in effect, a mini-incorporation process). Again, the entrepreneur should seek the advice of counsel with respect to choosing the state of incorporation.

3. Incorporate and Issue Stock ASAP. The venture should be incorporated and stock should be issued to the founders as soon as possible -- i.e., before the company has any significant value. Clearly, as milestones are met by the company subsequent to its incorporation (e.g., the hiring of employees, the signing-up of customers, the creation of a prototype, etc.), the value of the company will increase and therefore so will the purchase price of the stock (which could trigger significant taxable income to those founders receiving stock in exchange for past or future services). Moreover, if a founder intends to transfer assets (e.g., technology) to the corporation in exchange for stock, Section 351 of the Internal Revenue Code (which permits a tax-free exchange under certain conditions) may only be available at the time of incorporation and not later after more stock has been issued. Indeed, the same principle applies with respect to the issuance of stock options/equity to employees: the goal is to do it as soon as possible when the value of the company is as low as possible.

4. Impose Vesting Restrictions. The founders should impose vesting restrictions on the stock issued to them at the time of incorporation for two important reasons: (i) a vesting scheme will be required by the VC investors, and if a reasonable scheme has already been established, it is more likely that the investors will simply keep it in place; and (ii) it makes good business sense because, in most cases, the stock has been issued not only for services or property relating to the conception of the venture, but also for the founders’ continuing commitment and efforts -- indeed, it would be inherently unfair for one of the founders to leave the venture after a few weeks/months, but still be permitted to keep all of his/her shares. Vesting restrictions would, in effect, grant the company the right to repurchase any unvested shares at the initial purchase price at the time of the founder’s departure. It is generally advisable for any founders receiving shares subject to vesting to make a Section 83(b) election with the Internal Revenue Service, which will prevent the founder from recognizing income at the time the stock vests. Such an election must be filed within 30 days after the purchase date of the restricted stock.

5. Execute a Shareholders’ Agreement. If there are two or more founders, it may be prudent to execute a shareholders’ agreement in order to address certain significant issues, including (i) restrictions on the transferability of the shares (including rights of first refusal), (ii) voting rights, (iii) rights and obligations upon the death or disability of a founder and (iv) perhaps “drag-along” and “tag-along” rights. In the event there are only two shareholders with an equal number of shares, it may also be prudent to include so-called “deadlock” provisions in the shareholders’ agreement (such as a “Russian roulette” provision, a “Texan shoot-out” or a “Dutch auction”). Needless to say, the closer the corporation is to VC financing, the less importance a shareholders’ agreement holds because it will be superseded by the applicable venture documents.

6. Comply with Applicable Federal and State Securities Laws. A company may not offer or sell its securities unless they have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions. Fortunately for the start-up, however, there are certain prescribed exemptions which may be applicable, including Section 4(2) of the Securities Act of 1933, as amended (the “1933 Act”), and Regulation D promulgated thereunder (as well as Rule 701 discussed below). It is indeed imperative that the entrepreneur seek the advice of experienced counsel prior to the issuance of any securities: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution. The rule of thumb in this area is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506, which preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996. (Note: anti-fraud rules are still applicable under Rule 506.)

7. Protect Your IP. For many start-ups, intellectual property (“IP”), such as copyrights, trademarks, domain names or patents, is their most valuable asset. Accordingly, a number of steps should be taken to protect IP assets, including (i) developing a comprehensive strategy for IP; (ii) establishing and implementing IP policies and procedures -- e.g., concerning proper use of third parties’ IP; (iii) if appropriate for the business, filing patent applications and registering copyrights, trademarks and domain names; and (iv) as discussed below, requiring independent contractors and employees to execute confidentiality and IP/invention assignment agreements. Many entrepreneurs retain separate IP counsel to address some of the foregoing issues, particularly where IP protection is significant to the business model.

8. Address Employment Issues. If any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) a confidentiality and IP/invention assignment agreement. The offer letter agreement will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.” The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company. (Note: under California Labor Code Section 2870, an employer may not require an employee to assign rights in an invention that the employee developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.) Non-competition provisions may also be appropriate; however, such provisions are unenforceable in California other than in the context of the sale of a business -- though California courts will generally enforce contractual provisions that prohibit employees from soliciting the company’s employees, provided that such provisions are reasonable (i.e., not overbroad) in scope and duration. Moreover, it would be prudent for the company to create an employment manual setting forth the company’s policies (including with respect to equal opportunity/non-discrimination and sexual harassment) and establishing the parameters of the employer-employee relationship.

9. Establish a Stock Option/Equity Compensation Plan. In order to attract and retain key employees (and to conserve cash), it usually makes good business sense for the company to establish a stock option plan or other form of equity compensation plan. Again, the goal is to do it as soon as possible when the value of the company is as low as possible. As noted above, any offer or sale of securities must comply with applicable federal and state securities laws. Rule 701 promulgated under the 1933 Act creates an exemption from registration for any offer or sale of securities pursuant to certain compensatory benefit plans and contracts relating to compensation, provided that it meets certain prescribed conditions. Most states have similar exemptions, including California, which recently amended the regulations under Section 25102(o) of the California Corporate Securities Law of 1968 (effective as of July 9, 2007) to significantly liberalize the requirements under California law to conform with Rule 701. Moreover, under Section 409A of the Internal Revenue Code, the company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibility. The company can establish a defensible fair market value by (i) obtaining an independent appraisal or (ii) if the company is an “illiquid startup,” by relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company employee), provided certain other conditions are met. (Note: restricted stock is not subject to Section 409A.) Again, the entrepreneur should seek the advice of counsel before issuing stock options or other equity.

10. You Must Pay To Play. Based on the foregoing, it is self-evident that now is not the time for the entrepreneur/founder to try to save money by doing legal work on his own and/or by relying on printed forms from a web service. Indeed, there are a number of significant legal issues that must be addressed to protect the entrepreneur and his/her venture. Moreover, VC firms and/or other outside investors will be doing extensive due diligence on the company prior to making an investment and, accordingly, it is imperative that the entrepreneur demonstrate a certain level of credibility and sophistication. Remember: “starting companies is a lot like launching rockets: if you're a tenth of a degree off at launch, you may be a thousand miles off downrange.” The Silicon Valley Edge, edited by C-M Lee, et al. (Stanford University Press 2000), p. 328 (quote by C. Johnson, Esq.).